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Mitigating Risks in Property

Mitigating Risks in Property
June 17, 2020 Kenji Smith

As we explained in our last blog (Key Risks in Property Investing), there are particular risks when investing in the property market. This week, we will describe how to mitigate those risks and therefore invest with more confidence. However, before offering tips on what to look for when mitigating risks in property, firstly it is a good idea to select a platform that you are most comfortable with.

Questions such as:

How easily accessible is the platform?
Is it simple and clear to you?
How transparent is the information on their investments?
Are they responsive?

Answers to these questions will help give you more or less confidence in the platform. As investors have no direct control, it is paramount to have a reasonable level of comfort before investing.

Development Risk:

Platforms, such as Brickowner, apply a thorough due-diligence process before putting these investments forward. One important part of this, is the evaluation of the strength and experience of the property developer. Another important factor to consider is transparency. Investors should be able to see how, and their funds are used in detail. In addition, on-going reporting on the progress of a development is important.

Liquidity Risk:

Property development companies may run into cash-flow problems which can indirectly risk your investment. To mitigate this risk, most investments are in Special Purpose Vehicles (SPV). An SPV is a type of limited company that is created to segregate assets such as individual developments. This creates a ‘ring-fence’ around the investment, ensuring protection from the wider company’s balance sheet. This means that if other developments of that company fail, it should have little and no impact to your investment.

Planning Risk:

Selecting investments that have the planning permission already granted will greatly reduce the risk of the investment. If it has not been approved, it is important to check to the planning process for approval.

For example, do the property developers:

  • Work with experienced planning consultants in the local area so they are familiar with council rules and development strategies
  • Look at comparable developments made in the area to check its flexibility
  • This will increase the probability of the planning permission being granted, and thereby reduce risk

Financing Risk:

Most property developers will borrow in order to finance their investments. Therefore, to gain a better understanding of the associated risks, it is important to understand several metrics that help estimate the level of financial risk within the investment.

  • Loan-to-Value (LTV) The LTV is the ratio of the value of loan against the market value of the current property/site
  • Loan-to-Cost (LTC) The LTC is the ratio of the value of the loan against the total costs of the project. This determines how much the project is funded by debt against equity. The higher the LTC, the more risk the investment is taking on if the development struggles. The LTC ratio can typically reach a maximum of 90/95%
  • Loan-to-Gross Development Value (LTGDV) The LTGDV is the ratio between the value of the loan against the estimated market value of the development after all development works have been completed. A reasonable LTGDV ratio can typically reach a maximum of up to 75%, but of course will change either up or down, through the life of the development.

In real estate, leverage is a common way to increase the potential return of an investment. However, when the value of property decreases, leveraging increases the downside risk. Therefore, investors should be particularly aware of this financial level of risk, especially the metrics above. In addition, some developments borrow capital in smaller amounts, known as ‘tranches’. This helps maintain discipline within the project and therefore and ensure the funds are deployed at key milestones of the project.

Macro Risk:

Macro risk includes the state of the economy, movements in interest rates and inflation. These risks are outside the control of investors and developers alike. Therefore, the strength of the underlying property developer is critical as a stronger firm will be more able to ride out macroeconomic shocks. When economic downturns do occur, locations that have shown more resilience in price terms, will provide better downside protection. Finally, changes in government policies and regulations can have a material, positive or negative impact on property.

Returns Risk:

Although the rate of return is a key part when looking at whether to execute an investment or not, it is always important to check the documents and underlying assumptions for the investment. For example, some investments have incorporated a minimum hurdle of return before the property developers can share any profit. This means the property developer is fully incentivised to maximise returns.

Conclusion

Overall, investments in property contain a number of risks that need to be carefully considered carefully. Although property investment can generate very attractive returns for investors, there are a number of risks that need to be evaluated to ensure that it matches your risk appetite. A well-managed platform can offer investors a range of opportunities to allow them to diversify risk through investments in multiple developments, if they wish.